When China Sneezes . . . The US Doesn't Have to

As I write this, the Dow Jones is down about 400 points or just over 3%. The fall in US stocks is a carry over of the selling that occurred in China and the Far East overnight. Stocks in China fell by almost 10%, as investors sought to lock in profits in the face of a rumored Chinese crackdown on speculative buying and stock manipulation. The Shanghai domestic stock market has been nothing short of phenomenal, recently, racking up a gain in 2006 of 127% and 13% year to date. To say the Chinese market may have been a bit overbought, is an understatement of monumental proportions. But what does a sell off in the frothy markets in China have to do with the rest of Asia, Europe, and the US, where stocks have also sold off sharply? The answer is the interrelatedness of the world wide capital markets and economy. Welcome to the global economy. If any of the world's major economic players sneezes, there is the chance that the rest of the world may catch a cold. If you think of this in reverse, it may be more understandable. If the US would have reported an Enron like scandal yesterday that caused US stocks to fall sharply, today all the major stock markets around the world would be down in sympathy with us. We are so important to the world's economy that any disturbance in our economic prospects or confidence impacts everyone, because we are the largest consuming nation in the world. How about China? How important is it in the world's economic scheme of things. On an exchange adjusted basis, China is about one sixth the size of the US, and represents about one thirtieth of World Gross Production. Trouble in such a small portion of the world's economy would not seem to justify such a violent reaction to stock markets in the world's economic capitols. Indeed, we see few fundamental reasons for the world wide stock sell off, and we do not believe that economic growth estimates will change much as a result of today's sell off. Stocks sold off, mainly, because of the ease of selling. All you have to do is to turn go on your Internet and sell until your fingers wear out. In our judgment, in the days and weeks ahead today's selloff will be seen for what it is: a trading event and not a fundamental economic event. The fundamentals are still strong and stock prices will, ultimately, follow the fundamentals. How about the prospects that the US stocks markets, which had a good year in 2006, could be overvalued? There is good news on that front. US stocks did rise over 15% in 2006, but they are now selling at about the same PE and dividend yield than did at the beginning of 2006. The price rise in 2006 was entirely justified by the growth of earnings and dividends. US corporate earnings were better than expected in all four quarters of the year just past. The US economy is growing near 3%, and the Fed has stopped raising rates. If the economy were to slow for any reason, the Fed would quickly cut rates to spur economic growth. Finally, my friend Dr. Spear sent me an email and said, "Is this 1929 or 1987?" The answer, Doc, is neither. In 1929, on Black Monday, stocks fell by almost 13%. That would be equivalent today of nearly 1650 points. On Oct. 19, 1987, stocks fell by an amazing 22.6%, equivalent to nearly 2850 points today. The US markets have experienced numerous 3%-5% selloffs in its history. Few have led to any serious economic downturns. We are confident this one will not either. With US stocks having recently reached all time highs, some profit taking was probably inevitable sooner or later. The sell offs in Asia and Europe last night were just a good excuse for it to happen today here. While we believe the volatile markets will calm down in the days ahead, we expect that some additional selling may occur in the near term. We have put together a buy list of terrific companies that we would like to own, we hope we get the chance to do some nibbling. China may have sneezed. They might even have a cold, but our economic strength will help us ward off any cold bug, and, indeed, help pull them out of their chill. We'll keep you posted on any changes in our thinking.

Airbus Cries Uncle, Boeing Tightens the Noose

The news this weekend from Europe is that Airbus, the European quasi-public aerospace company, and Boeing's biggest competitor, has delayed the announcement of its planned restructuring. The reason: France and Germany, the two main governments behind the project, are battling over how many layoffs they must absorb in their respective countries. Reuters reports the following: In a sign of renewed tensions within EADS, French co-CEO Louis Gallois -- who also heads Airbus -- defended his restructuring plan in a separate statement issued by the Toulouse, France-based aircraft maker. "I made proposals which I deem balanced, both from an industrial and a technological point of view, and which serve our objective of economic competitiveness," Gallois said. "Airbus cannot delay any longer implementing Power8," he said. France's two main financial newspapers, Les Echos and La Tribune, reported Monday that Gallois is seeking to cut close to 10,000 of the company's 55,000 jobs, sell off some production units and centralize assembly of the A350 in France, in exchange for agreeing to build a future revamp of the single-aisle A320 airliner in Germany. Under the plan, France and Germany would each contribute between 3,000 and 4,000 of the job cuts, Les Echos said. Neither paper named sources. Airbus and EADS both declined to comment on the restructuring proposals or the discussions. You will recall recently I discussed the very favorable position in which Boeing's new CEO, Jim McNerney finds himself. He has new aircraft that the airlines want, and he is on schedule to deliver them. McNerney has the manageable problem of motivating all of the "princes" at Boeing to subjugate their interests for the good of the company's competitive battle against the "kings" at Airbus. This weekend, France and Germany, two of the "kings" are at odds over who has to absorb the most layoffs and who gets to build the new airplane. Two CEOs, three countries, countless unions, overdue planes, and Airbus' blood is in the water. There are plenty of "kings" but no captain. Jim McNerney left a great job at MMM to take a job that nobody has done well for a decade at Boeing. Many wondered why; now we know. Airbus is very close to Airbust. Of course the Franco-German consortium will bail out Airbus but at a terrible cost to their competitive position. If Boeing can stay humble, the remainder of the first decade of the 21st century will be theirs. If they can stay hungry, perhaps they will own the second decade outright. We own BA in our Capital Builder investment style. Please review our conditions for using this site.

Gentle Ben is Not a Bear, He's a Bull

Fed Chairman, Ben Bernanke, gave the first leg of his semi-annual report to the Congress on the condition of the economy today. As he began reading his prepared text, he knew what would soon be happening in the capital markets. He knew his "not too hot, not too cool" comments about the economy would rally both stocks and bonds.

But of equal importance was that he also knew that almost all of the world's stock markets were near multi-year highs. Thus, a speech emphasizing a balanced view of the economy would likely send stocks to new highs and give momentum to the world-wide bull market, while a more cautious tone would likely cause a sell off in stocks and keep animal spirits in check.

Ben was gentle, and he turned the bulls loose.

The charts below show the S&P 500 Index, which represents about 85% of US market capitalization and the EAFE Index, which measures the majority of the rest of the world's market cap. These two charts show that US and world-wide stocks have been in a solid uptrend since June. Both charts also show that US and international markets have been biding their time over the last month, digesting earnings and waiting for Mr. Bernanke to speak. Finally, both charts show a break to new multi-year highs today after Mr. Bernanke spoke.

None of us can see the future, but this much we can know. Mr. Bernanke knew what he was doing when he took a balanced tone, and he knew what would happen. We can only conclude that he believes that the soft-landing we have all been hoping for is playing out.


Please click to enlarge the images.

Boeing is Still Cheap

In recent days Boeing has popped higher on news of new orders for planes and continued delays on the Airbus A380 jumbo jet. I think the good news is likely to continue at Boeing as much for the troubles at Airbus as for BA's new CEO, James McNerney. McNerney has a pedigree that is hard to match, having had stints at P&G, GE, MMM, and now Boeing. If he lives long enough, he may be the first person in history to manage all 30 of the companies in the Dow Jones Industrial Average. In this case, however, it is not his impressive pedigree that portends continued success at BA but his unique success at MMM. When McNerney joined MMM, it was a wonderfully innovative company that many investors had soured on because the company had a history of discovering great products that either fizzled or were copied by other companies that could produce and market the products more profitably. MMM had many wonderful innovations slip through their fingers because their product list was so long and ever increasing, and they never got around to betting and backing the right horses in their stable. At MMM, McNerney built consensus around the idea of "commercialized innovation." In some ways, it was really very simple. He sold the employees on narrowing their focus to a smaller list of innovative products that had sustainable profit potential and barriers to entry. In addition, he reduced redundant layers of management and put a quantitative tracking system in place that measured all the bets. Wall Street applauded his initiatives and the stock moved higher. Boeing is a tougher nut to manage than MMM because of its huge capital commitments and the winner-take-all nature of the commercial and military aerospace industries. Additionally,Airbus, its only other viable competitor, has the backing of the governments of Germany, France, and Spain. BA has won many contracts and made deals at the four corners of the earth, but they have not consistently given back much to their investors. Indeed, operating earnings for 2005 were about the same as they were in 1991. I think McNerney is the right person for one of the most important jobs in the world, because he is a consensus builder, and he knows how to allocate capital, having learned this from the master, Jack Welsh, while at GE . I believe McNerney will lead BA much the same as he did MMM, by consensus and focus. There are too many layers of management at BA, but what's worse is that there are too many "princes" who believe that their view should be the company's view. No company stands to gain more from the global economy than does BA, but it cannot continue as many little companies within a company. I believe McNerney can convince most of the"princes" that their kingdoms will prosper if the stock price continues to go higher, and the stock price will go higher if the company is able to do a better of job of allocating its capital and has a better focus on the bottom line. Those princes he is not able to convince will probably be looking for employment elsewhere very fast. If you want a powerful way to think about Boeing it is this: Boeing has what amounts to a toll road across every continent and ocean in the world. I am not completely ignoring Airbus. It is a strong company, but a focused, disciplined strategy by Boeing will be nearly impossible for Airbus to compete with. It has two CEOs, it is sponsored by three European governments, and is a subsidiary of another publically traded company, EADS. Where Boeing has princes, Airbus has kings. In this regard, I think the better bet is against the kings, espescially with Jim McNerny on our side. I think the stock may be 15% undervalued. We own BA in our Capital Builder style of management. Please see terms and conditions of this website on the sidebar at the right.

Dividend Valuation Update -- P&G and Colgate Shine

I just completed an update of the dividend valuations of the 10 major industry sectors. The leaders and laggards have not changed much in six months, but the earnings news in recent days corroborates some of the data that I see. The two sectors that are most undervalued are the Consumer Staples and the Industrials. I will have more to say about the Industrials in a future edition.

Today both Proctor and Gamble and Colgate reported better than expected earnings, emanating from their emerging markets businesses. P&G was strong in China and Asia, while Cl had an outstanding quarter in Latin America, where the company claims it has a market share over 70%.

In the face of interest rate worries, these two companies would seem to be a natural place for money to flow because neither company is particularly sensitive to rising interest rates. Indeed, according to our models both stocks are undervalued with Colgate being the best bargain at nearly 15% below its Dividend Valuation's intrinsic value. The chart below shows the historical relationship between CL's Dividend Valuation Model and its actual price.

............................ Colgate Dividend Valuation .................

The green-striped bar is our model's projection of CL's value during the next 12 months. Including dividends the expected return is nearly 17%.

Of course, you can't take that kind of a return to the bank. It's just an educated guess, but looking at the economic landscape before us, I would not be surprised to see the staples, and particularly Colgate, continue to shine in 2007.

Mike Hull Was Right. . . So Far

In September, DCM president Mike Hull answered a question from a client regarding the medias' worries that a hard landing was inevitable and gave our case for a soft landing. Mike said the media was wrong, as usual, on the hard landing scenario because they did not understand that while the Fed had pushed short-term interest rates much higher, long-term rates were still very tame, which would allow the economy to continue to put up positive numbers. So far, he has been right on. The worries of a recession have faded with every new economic release, and the corporate earnings reports have just been terrific. Indeed, the talk in recent days has been that the Fed may have to raise rates because employment has stayed so strong, which has kept core CPI higher than many had hoped. In our investment meeting this week, we discussed what to make of these "hot" numbers. We are still firmly in the camp that's calling for a soft landing, but we believe the recent stronger-than-expected economic data are being modestly inflated by the unseasonably warm weather that the country has enjoyed this winter. The data that the government reports is seasonally adjusted. Over the years, we have witnessed countless times when economic releases were distorted by weather. Hurricane Katrina distorted economic data for six months after she made landfall. Fourth quarter 2005 GDP was nearly 40% less than had been expected and everyone began to fret that the hurricanes would cause a recession. We explained, then, that a rebound was coming. First quarter 2006 GDP completely made up for the fourth quarter shortfall. We believe the same thing will happen again. The economy is putting up strong numbers now, but the numbers are inflated by the warm weather, and we do not believe thet are sustainable. Over the next few months, we should see a rapid retracement of much of the data. And we suspect the doomsayers will start talking about a hard landing again. But we believe once the data calms down they will show that a soft landing is, indeed, underway. Recently, in our client letter we said that we thought the Fed's next action was to cut rates, but that they would be doing so later rather than sooner. That is still our position. We also said that the stronger-than-expected economic data could be a headwind to the stock market in the short run, but that the headwinds would pass as it became clear that the economy was not accelerating. That is also still our position. Recent strong economic data has thrust Ben Bernanke and the Fed back in the headlines. There will be lots of "will they or won't they" talk regarding interest rates. We are convinced that the Fed is done raising rates, and we aren't worried that they will change course. One big reason is that the mild weather has masked the weak real estate markets. While real estate weakness is not nationwide, sooner or later its effects will become apparent in the economic data. Blessings,

Phoenix Trip

I will be in the Phoenix area for the next few days visiting family and clients. If any Donaldson Capital clients are vacationing in the area and would like to meet, please email me at gdonaldson@dcmol.com, and I will try to arrange something. Never seen so much blue sky.